Fertility, Capital Returns, and the Optimal Inflation Rate

If the fertilitarians (or, what should I call them? demographiles?) are right, their ideas have an interesting implication for monetary policy. If anticipated dependency ratios are necessarily to have dramatic effects on a society’s ability to support retirees, it must be the case that capital and labor are not very good substitutes. If capital could be easily substituted for labor, then a society could simply accumulate enough capital to replace the labor that won’t be available to support future retirees. If capital and labor are not very good substitutes, then the marginal product of capital will change significantly depending on how much labor is available to work that capital and how much capital has been accumulated relative to the available labor. Facing the prospect of a large capital stock (accumulated by those intent on retirement) and a small labor force (as growth of the working age population slows relative to the retired population), the expected marginal product of capital would decline. Classical economic theory tells us that the real interest rate should equal the marginal product of capital (less any applicable risk premium) in equilibrium. So, as a large cohort approaches retirement, the real interest rate should get very low. The real interest rate also tends to vary over the business cycle, becoming lower during times of economic weakness. If the fertilitarians are right, we can expect that the real interest rate will be low in general as a large cohort approaches retirement, and that that it will be particularly low – probably significantly negative – at business cycle lows that occur during that period. For the actual real interest rate to be negative, we need positive inflation. And the lower the equilibrium real interest rate is expected to be at its nadir, the higher an inflation rate we would need in order to actualize that low real interest rate. Thus, if you believe the fertilitarian argument, you should also believe that the optimum inflation rate is higher than it otherwise would be.

Jane Galt is Right

I may disagree with Jane Galt about controversial topics like taxes and income distribution, but when it comes to basic issues like public whipping, we’re in full agreement:

…deterrence and retribution are legitimate questions of justice--but I also think that jail is lousy, immoral, and highly inefficient way to achieve them.

Lousy because jail makes the criminals cost us money. Yes, courts cost money . . . but what costs money is the troublesome process of sorting the innocent from the guilty. We're spending money on the blameless, not the perpetrators. Once they're convicted, we know (as well as frail humans can) that they're guilty. Why should we spend money to punish them, when they could be making money, or hey, just entertainment, for the society they've wronged? Fastow's skills may not be much, but stick an ankle bracelet on him and set him to painting overpasses or something.

Inefficient because criminals are very bad discounters of time, or they wouldn't be criminals. Expensive, long prison terms aren't very effective deterrants. Optimal punishments are short, extremely harsh, and immediate.

Immoral because the great tragedy of human life is the finiteness of time; I'm not sure we ever have a right to take away someone else's pitifully few moments simply to punish them. Locking people up because they are a danger to others is a necessary evil; locking them up because we can't think of anything else to do to them is not. Morally, I should think a public whipping post vastly preferable--and more effective--than a one-year jail term.

My readers, particularly my more sensitive liberal ones, are even now recoiling in horror at my barbaric suggestion. But we all know that in fact the real punishment offered by prison is that meted out by other prisoners--that for many or most people, a prison sentence is a long and barbaric series of beatings and rapes. We know that this is true; we do almost nothing to prevent it; and we send people there anyway. Indeed, this is the aspect of prison--not the incarceration away from families, friends, and good takeout--with which cops threaten suspects. I should think a clean, quick beating from a government official would be more to anyone's taste--except the of course the animals who rule the prison dominance hierarchy.

Tucking criminals off in prison simply allows us to pretend to ourselves that we are doing something not-so-bad, when what we really intend is full-blown evil. If jail really were merely a dull spell of menial service jobs and mediocre food, I suspect many Americans would think it wholly inadequate to the demands of justice.

Yes. I made the same suggestion about 20 years ago, for essentially the same reasons. Suffice it to say, the suggestion was not well received by my lunchmates. (“Wouldn’t the state be liable for welts?”)

But think about it. Our current system essentially outsources punishment the same way the CIA outsources torture. (“We’re not being inhumane. The inmates promised not to rape anybody.”) And the worst criminals end up getting the least punishment, because the worst criminals are exactly the ones to whom the punishment function is outsourced.

If I have come to have reservations about public whipping, it is only because I have become more of a fascist over the past 20 years. As a utilitarian, I tend not to buy into the whole concept of “justice.” The purpose of prisons, as I see it, is to prevent crime. The best way to prevent crime (so the empirical evidence indicates) is to put people in jail before they commit crimes. Unfortunately, the justice advocates generally object, because they say it’s unjust to punish people who haven’t yet committed crimes, and of course there is also the practical problem that we can’t predict with much accuracy who is going to commit a crime. But when someone does commit a crime, it provides both (1) a fairly good predictor of future criminality, and (2) a good excuse to get around these silly “justice” concerns. So there is a good case, it seems to me, for putting criminals in jail.

Nonetheless, whipping would be cheaper, and it might provide good entertainment for some people. We’d have to weigh the costs and benefits. And for white-collar criminals, who are unlikely to have criminal opportunities in the future, the case for whipping over prison time is pretty much a slam dunk. OK, Mr. Fastow!


UPDATE: Chris Dillow made the same suggestion in June (as he notes in the comments here). Interestingly, he doesn’t make the argument (our trump card, as I see it) that prison life is already at least as brutal as state-inflicted corporal punishment. Perhaps that’s not so true in the UK. If we have 3 bloggers on board already, perhaps we should start a club, analogous to Greg Mankiw’s “Pigou Club”. Call it “the Corporal Punishment Club”? But that sounds slightly perverted. How about “the Effective Deterrence Club”?

Fertility Position

Has Greg Mankiw changed his position on the importance of fertility? Edward Hugh thinks so:

I recently berated Greg Mankiw (and the top ten world economists he pretends to cite) for the folly of suggesting that fertility rates don’t matter to economists. Well today Mankiw seems to be having (an implicit) rethink. Dependency ratios, it seems, do matter.

Now since dependency ratios are really a function of three factors - fertility, life expectancy and net migration - it is hard to deny the obvious: that fertility is important.

In the first cited post, Greg said:

If you polled top economists and asked them to name the major economic problems facing Europe, China, Japan, and South Korea, I doubt that insufficient procreation would rank high.

In the second post, he cites Jeremy Siegel, who says:

Because of our aging population, I calculate that the average retirement age will have to rise by 10 years or more for workers to produce enough goods and services to provide for a comfortable retirement. This increase will greatly exceed the expected increase in life expectancy and lead -- for the first time in history -- to an absolute reduction in the number of years in retirement.

Anyone who has read my last two posts on the subject will recognize that I hold more with the first Greg Mankiw than with the second. But I’m not sure there is really a contradiction. Greg never said that fertility doesn’t matter; he only said that it wasn’t a big problem.

The big problem for the US is that, given our fertility rate, and given our retirement aspirations, and given our limited ability and/or willingness to accept immigrants, we as a nation are not saving enough. (Even that point is debatable, but it’s pretty clear that’s what Greg – along with the vast majority of economists, including, ultimately, me – believes.) One solution (but it’s pretty much too late now) might have been to have more children, but that probably wouldn’t have been a very good solution. Beyond the inherent moral problems with treating children as a means to an end, and the political problems with instituting fertility policy in a nation like the US, it’s not even clear that increased fertility would be an efficient way to solve the problem. A larger population would place a greater strain on the natural resources available to the US: we might still end up better off, but it’s far from an open and shut case. As for saving more, it offers a pretty clear advantage, retirement-wise, over saving less. A critical question, however, is to what extent we would be able to substitute capital for labor. I’m guessing that most of Greg’s hypothetical top economists don’t see that as a major difficulty.

In Europe and Asia, the issues are somewhat different. Asians, at least, are certainly saving enough already. If anything, the problem is that they are saving too much and running up against Keynes’ paradox of thrift. The US is conveniently providing a source of demand. What will happen if Americans finally get religion and start saving? One might reasonably worry about a worldwide Keynesian demand failure of the same genre as the 1930s. But could such a failure be blamed on demographics? After the 1930s, it was the recovery that came first, and then the baby boom.

Free Trade and Exchange Rates

I’m all for moving the yuan toward a float more quickly, but this (from a Wall Street Journal commentary [hat tip to Mark Thoma] this morning by Senators Schumer and Graham) is just silly:

One of the fundamental tenets of free trade is that currencies should float -- or at the very least, move along with market forces. The reason for this is that a free-floating currency allows large trade imbalances to self-correct...

One of the fundamental tenets of free trade? So it’s impossible to have free trade under a fixed exchange rate regime? Come on, guys, you can do better. At the very least, it is widely recognized that exchange rate pegs can be an effective way to stabilize inflation when other methods don’t work or can’t be applied, and in that situation, it is critical to resist market forces that often don’t, at first, trust the stabilization.

More generally, in the presence of fixed exchange rates, large trade imbalances are ultimately expected to self-correct anyhow, through the mechanism of inflation. To maintain an undervalued currency, a nation normally has to follow an expansive monetary policy, which leads to rising prices and wages, making its products less competitive. Or, to look at it a little differently, the foreign demand occasioned by a weak currency strains the resources of the export sector and causes its prices and costs to rise, making its products less competitive.

China today is a special case for several reasons. First, there is a rapid flow of workers into the industrial sector, and this flow is helping to prevent the inflation that might ordinarily attend an undervalued currency. Second, much of China’s foreign exchange intervention is sterilized, which is to say, China is making attempts to slow down domestic sources of demand to compensate for the foreign demand occasioned by its weak currency. Third, China’s government is effectively running a very large surplus, which also tends to slow down domestic demand. Fourth, arguably, China is following policies that encourage a high level of private saving, which also tends to slow domestic demand.

The second of these factors, sterilized intervention, might reasonably be considered an unfair trade practice (and probably a foolish practice as well). The third and fourth factors, high public and private saving, respectively, while almost certainly “bad policy” from an international perspective, fall well outside the usual sphere of trade policy. As for the first factor, one has to wonder: if China has a lot of workers available to do these jobs, whereas the US has only a few (relatively speaking), why shouldn’t trade be set up to create jobs in China rather than the US?

Later on, Schumer and Graham assert:

Unfortunately, the Chinese appear to be content with the status quo. Their exports to the United States create millions of Chinese jobs and have allowed China to become the second-largest holder of U.S. government bonds in the world. They have no reason to change unless we send a very strong message that the status quo is not acceptable.

They make it sound like the Chinese enjoy accumulating US government bonds. I’m sure even the most conservative among the Chinese leaders are beginning to feel just slightly uncomfortable with the amount of US bonds they are accumulating – bonds which, when the eventual adjustment does come, will lose much of their value in terms of yuan. The Chinese clearly do have a reason to change; the problem is, those Chinese leaders who would advocate more rapid change have not as yet managed to make a strong enough case to those who don’t. Will pressure from the US help them make the case? Maybe, but it strikes me as rather a dangerous tactic.


UPDATE: Greg Mankiw makes the same point. I would note, though, that the specie-flow mechanism discussed by Hume isn’t quite working in this case, for reasons described above. To the extent that China is able to absorb ever-increasing amounts of US government securities, Hume’s mechanism may not apply.

Acorn Clarification

In my previous post regarding the effect of demographics on asset prices, I asserted that “a stock does not represent an infinite stream of dividends subject to the market’s valuation; it represents a finite stream of physical returns.” In the comments section, Gabriel Mihalache appropriately asks for clarification:

…could you please expand on your comment regarding shares? I thought that shares entitle you to dividends in perpetuity, or at least as long as the company exists. When the company sells more, their value depreciates, but ignoring this, I don't understand what you mean by finite stream of physical returns.

It’s certainly true that dividends are what shareholders actually get, for as long as the company keeps paying them, which in the case of successful companies, is usually in perpetuity. However, the payment of those dividends represents the productivity of the underlying assets (e.g. plant and equipment), and any particular asset will typically tend to depreciate (become less productive) over time (or at least, will tend to have a finite useful life). The critical question is what happens when those underlying assets depreciate.

A corporation has a choice about what to do with its cash flow as its current assets approach the end of their useful life. It can invest in new assets, or it can return money to shareholders by means of dividends and stock buybacks. Since corporate managers generally seem to be very concerned about their stock prices, it seems likely that they will tend to make this decision based on maximizing the stock price. When there are a lot of working-age people who want to invest, there will be a lot of demand for companies that invest in productive assets, and the stock market will presumably favor stocks of companies that reinvest their cash flow. If you can say, “Look, we’ve invested in this great new project that is going to produce great returns in the coming years,” people will want to buy your stock.

On the other hand, when most of the population consists of retirees, there won’t be a lot of demand for companies that invest in new productive assets. Rather, stockholders will want to take what the company produces and just consume that product, while allowing the assets to live out their limited useful life. In that case, the stock market will favor companies that pay high dividends and use their excess cash to buy back stock. If you expect to live only another, say, 15 years, you’ll be willing to pay a premium for a stock that promises good payouts over those 15 years even if it will start to become worthless afterward. So even though the transactions are financial and involve things like dividends, the investors ultimately control whether a company reinvests the proceeds from its physical assets, and it is roughly as if those investors owned pieces of those assets directly.

Thus when Prof. Siegel imagines seemingly perpetual financial assets that depend on market demand for their value, he is creating an artificial construct. Ultimately, a stock represents part of (for example) a factory, and a factory really is like an acorn. The squirrels who own it can choose when to consume its output.

Demographics and Acorns

In Wednesday’s Wall Street Journal Jeremy Siegel (cited by Greg Mankiw) argues that demographic trends (the increasing fraction of older people among the populations of developed countries) will doom future US retirees unless developing nations are willing to start buying US assets:

Instead of stepping into an easy retirement, many retirees will tumble into a future marked by bankrupt government social programs and declining asset values that will quickly deplete their cherished nest eggs….This forecast is not based on an unpredictable future, but on events that have already transpired.

Well, OK, the demographics are based on events that have already transpired, but demographics are only part of the story, and in order to get the outcome Prof. Siegel suggests, the unpredictable future has to turn out in a certain way. In particular, productivity growth is unpredictable, and future saving behavior is unpredictable, and if they both turn out better than Prof. Siegel expects, or if one of them turns out a lot better than Prof. Siegel expects, then at least some of those dire consequences will be avoided.

There are a lot of issues here to wrap ones mind around, so I may have several posts on this subject, but let’s start on the asset value issue and go for now until I run out of steam. Prof. Siegel argues that retirees will want to liquidate assets and, with so few working-age people around to buy those assets, there will be little demand, and prices will decline. I wouldn’t rule out that scenario, but I have several problems with it.

The first is a basic theoretical problem. Asset returns should depend on two things – time discounting and the price of risk – but I don’t see why either of these things should be affected by future demographic conditions. A risk-averse person investing for retirement today can choose to invest in bonds and annuities which will provide a return – through the time of their retirement – that is known with near certainty in advance. These assets can be chosen to mature at exactly the right time, so there is no need to worry about finding buyers. Thus any demographic issues that might exist are already priced into the safe assets. As for risky assets, their price today should be based on an expectation of what their return will be relative to the safe assets. If current prices don’t allow for a sufficient return, enough to compensate for the return on the safe assets and provide a premium to compensate for the risk, then why would anyone buy them?

OK, maybe someone will buy them because they haven’t read Prof. Siegel’s research and don’t realize how low the returns will be. But I still have a problem. If the asset returns are going to be so low, then people are saving way too little today. The way to make up for low asset returns is to save more. Presumably, people will eventually realize this and start saving more. But when they do start saving more, the demand for assets will go up, and presumably asset prices will go up. So the story about low asset returns is not actually a story about today’s investors; at best it’s a story about future investors, the ones who buy after asset prices go up.

And there’s a further issue. According to Prof. Siegel,

In a modern economy, wealth does not represent “stored consumption,” such as a cache of acorns that squirrels bury to bide them through a long winter. You cannot consume your stock certificates, but must sell them to someone else who wants a chance to consume at a later date. If there is a shortage of these savers, this may cause a long and painful bear market in stocks, bonds and real estate that will leave retirees with insufficient assets to enjoy retirement.

But in an important sense, wealth does represent stored consumption. Stocks, the most important type of risky asset, represent ownership in a productive enterprise, and most productive enterprises have a depreciation aspect. A stock does not represent an infinite stream of dividends subject to the market’s valuation; it represents a finite stream of physical returns. If people purchase stock, corporations will make physical investments that will produce physical returns to take care of those people during retirement. Granted, the return on physical investments will tend to fall as more and more such investments are made, but there is no reason to believe we are reaching a point of severely diminishing returns any time soon.

OK, I’m out of steam, for today.

Another Problem with the Anti-Core Argument

Following up on my previous post, I want to make an empirical point about Caroline Baum’s argument. She argues that a long lag cannot explain the failure of non-oil prices to adjust downward in the face of rising oil prices:

You might counter by saying that the price of something else will fall with a lag, not simultaneously; that when gas prices go up the consumer doesn't immediately cut back on his non-oil purchases.

Let's go to the video tape. The consumer price index was running at about 2 percent year-over-year during the deflation scare in the middle of 2003. Crude oil prices were hovering near $30 a barrel.

Three years later, with crude oil prices hitting a record $78.40 in July, the CPI was rising 4.1 percent. In all that time, the price of something else should have fallen to offset the higher oil prices. The fact that it didn't means our friendly central bank was accommodating the oil-price increase, printing enough money to prevent that from happening.

But there’s a problem here (beyond the theoretical problems mentioned in my previous post). First of all, nobody disputes that the Fed was accommodating the oil price increases in 2003 and 2004. So it shouldn’t surprise anyone that non-oil prices failed to adjust during 2005 and the first half of 2006. At the time (2003 and 2004), the Fed had legitimate concerns about a soft economy, but the economy subsequently proved to be stronger than the Fed had feared. It turned out that the intentional easy money policy of 2002 and 2003 had been successful.

As 2005 went on, however, the Fed stopped accommodating the oil price increases, and in 2006, the Fed has even started pushing the other way. This is where the lag comes in. Because there really is a lag in the behavior of consumers, we won’t know until 2007 (or maybe even 2008) whether the oil price increases (which continued through 2005 and the first half of 2006) have reduced demand in the rest of the economy, as Ms. Baum would expect if the Fed were behaving itself. My guess is that, when all the votes are in, we will find that inflation has lost and that the Fed was right to ignore the direct effect of oil prices.

Bernanke vs. Baum

Fed Chairman Ben Bernanke argues that targeting core inflation is appropriate because, otherwise, the Fed would have to “force down wages and other prices quite dramatically to keep the overall price level from rising” in the face of rising energy prices. Bloomberg columnist Caroline Baum (hat tip: Mark Thoma) objects:

In order to offset the immediate effect of a rise in energy prices, the Fed wouldn't have to do anything. The price of something else would fall, all things equal, as consumers adapt to the constraints on their budgets (paying more for gas means less money for other goods).

I have (at least) four problems with Ms. Baum’s argument.

First, I have a basic philosophical problem with clauses like “the Fed wouldn't have to do anything.” What exactly is meant by not doing anything? I suppose they could hang “Gone Fishing” signs on the doors of all the Federal Reserve Banks and tell all the employees to go home and be with their families for a few months. No doubt this would succeed in getting prices down, but I don’t think it’s what Ms. Baum has in mind. It’s really quite arbitrary what course of Fed action is defined as being passive. Keep the monetary base constant? Keep the interest rate constant? Increase the monetary base at a 2% annual rate? At a 10% annual rate? Follow a Taylor rule? Ms. Baum’s whole argument is premised on the idea that there is some “default” course for the Fed. But who gets to define that default? No doubt she can define the default in a way that will produce, on average, the results she imagines, but someone else will define the default differently.

Second, let’s accept the default that she perhaps has in mind, maybe some ideal constant money growth rule, and let’s assume away all the uncertainties about velocity of money and potential output. Increases in the average price level are caused, according to the cliché, by “too much money chasing too few goods.” Ms. Baum assumes that “too much money” is the problem. In the case of energy, however, it is more likely “too few goods.” In other words, if the Fed were following a passive money supply rule, an adverse oil shock would cause the average price level to increase anyhow. If oil becomes scarcer but money remains equally plentiful, the value of money – in terms of some basket that includes oil and products made with oil – will go down.

Third, even if my first two objections didn’t apply, let’s just imagine that Bernanke is using imprecise language by casting the Fed’s behavior as active rather than passive. Let’s say it is not the Fed but the market that has to “force down wages and other prices quite dramatically to keep the overall price level from rising.” That’s still a bad thing, because most wages and prices don’t go down without a fight, and the fight usually takes the form of a recession. The Fed is willing – actively or passively, depending on your economic theory and your semantic preferences – to accept temporary increases in the headline inflation rate in order to avoid unnecessary recessions. That strikes me as not only good judgment, but also the clear duty of the Fed under its current mandate.

Finally, let me make a basic point about the nature of oil as a commodity: oil is storable. If the price of is expected to rise, there will be strong incentive (provided that storage costs and interest rates are not too high) to hold large inventories in anticipation of higher prices. In practice, we never observe huge inventories, because producers, facing expected price increases, choose to delay production, which causes prices to increase immediately. In any case, the nature of the oil market is such that, normally, the most knowledgeable people will never, on average, be expecting large price increases. Otherwise, those price increases would already have happened. If the Fed’s objective is to stabilize prices going forward, then the Fed is operating well within reason to assume that oil prices will not rise dramatically. It is taking the market’s judgment, effectively outsourcing the task of forecasting oil prices. Past increases in oil prices are irrelevant, and it is rational for the Fed to ignore them by using core inflation as its measure of past price growth.

Retirement Savings

A recent paper (Scholz, Seshardi, and Khiatrakun, Journal of Political Economy, August 2006), cited by Tyler Cowen, finds – contrary to the conventional wisdom among economists – that most Americans are saving enough for retirement (at least assuming that Social Security, Medicare, and pensions come through as planned). Arnold Kling isn’t so sure:

…the median net worth in the data [a sample of households age 51-62] is $102,600, which does not impress me. The median "optimal" net worth as calculated by the authors is $63,116, which impresses me even less.

I admit that I’ve also been one who participates in the conventional wisdom, but as I think now about the typical life cycle, it doesn’t seem so unreasonable that people would not have saved very much by their mid-50s. Without looking at any actual statistics, I suppose a typical couple has their last child when they are in their early 30s, and their incomes continue to rise until they are in their mid-40s. Facing rising incomes and nonrecurring child care expenses, a couple in their 30s would be rational to borrow money. By their mid-40s, when their age-earnings profile starts to flatten, they will have substantially negative net worth. They continue to have nonrecurring expenses until their early 50s, when their kids graduate from college. So at best, by their mid-50s, they have just gotten past paying back the debts that they accumulated during their 30s. The real retirement savings is just beginning.

The typical couple in their mid-50s should have an income significantly above the national median, since that median includes all the young people at the bottom of the age-earnings curve. And they should be saving most of that income, now that they no longer have to pay their children’s expenses. But do people in that age range really save most of their income? My guess would be that they don’t. It would be interesting to see how sufficiency of savings correlates with age among the sample studied by Scholz et. al..

UPDATE: Brad DeLong weighs in (with some comments added by Yours truly). Brad makes the important point that income and prices have grown significantly since 1992, when the data for the study were taken, so that $63k is more like $110k today.

Stumbling

I have to mention Chris Dillow of Stumbling and Mumbling, because he has so many interesting things to say. As far as I can tell from his profile, he is not really an economist, but for someone who plays an economist on the Internet, he gives a very convincing performance. He seems to write from the perspective of a sensible left-wing libertarian. There are sensible left-wingers, and there are sensible libertarians, and there are left-wing libertarians, but it never occurred to me before that you could get all three into one package.

Income Distribution and Monopoly Rents

Maybe I am a lefty. In any case I find this discussion of income distribution (by Maynard of Creative Destruction) rather compelling:

I think one thing that's going on with the income distribution is this. With the development of communication and computer technology and the greater reach of large corporations in the last several decades, our productive technology is increasingly characterized by scale economies (I haven't read Rosen's Economics of Superstars, AER 1981, in awhile, but I think my argument is related to his). Two examples. Microsoft dominates the "market" for operating systems because of network effects: the more people who use Windows, the more valuable it becomes for the marginal user. Tom Hanks gets paid an outrageous amount of money because the distribution of his movies has become so sophisticated. It costs next to nothing at the margin to distribute one more copy of the same movie, so he is able by dint of a slight advantage in talent over a performer that no one has ever heard of to dominate the market. This means that there are huge monopoly rents that are up for grabs across huge swaths of the American economy. In the old days when the economy was insulated to some extent from the rest of the world and workers were represented by strong unions, you might have seen workers take a big chunk of these rents. But in the present environment, the rents go to those in the strongest bargaining position, namely the executives at large corporations and institutions and the performers who always have the recourse to walk away from the next film (or music, or sports) deal. So Brooks is right that our "meritocracy" is rewarding people based on individual talents, those who are organized, self-motivated, and socially adept. But the talent that is being rewarded is the talent to extract rents, not the talent to produce a higher quality product than the competition. Rewarding that particular talent produces no benefits for society; there is no economic argument to justify such a meritocracy, no economic basis for opposing, say, a steeply progressive tax system that would counteract some of the forces pushing us toward greater income inequality.

In fact, progressive taxation is more efficient. People in the bottom half of the income distribution aren’t getting much of the rents. They’re being paid roughly their marginal product, and taxes would distort their labor/leisure decision. People near the top of the distribution are the ones who have succeeded in capturing rents. They are being paid much more than their marginal product, and taxes actually correct a distortion in their labor/leisure decision.

Note, however, that these arguments don’t apply to capital taxation. (Maybe I’m not a lefty, after all.) If an individual has a lot of capital income, it is probably because that individual had a lot of capital to invest, not because she is capturing a disproportionate amount of rents in her capital income. So there is no efficiency justification for progressive taxes on capital income.

The Chinese Exchange Rate and US Borrowing

One cool thing about having my own blog is that I get to comment on Tyler Cowen even when he closes comments. (This is even better than bringing back deleted comments from Brad DeLong’s blog.)

Tyler Cowen argues against pushing for yuan revaluation on the grounds that revaluation would only tie the hands of the US:

The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility. I don't see how pressuring a more rapid change in one set of relative prices (namely U.S. vs. China), which are likely to change anyway, will cure that ailment in a significant way….

A key reason to be skeptical of yuan revaluation is that it tries to address a relative prices problem by shrinking the opportunity set facing the U.S. That is not obviously the right way to go. The point is not to claim that all elasticities are zero, but rather that a trade balance shift, through revaluation, really does require a loss of resources. What fact about the world would make that the best way to go?

What fact? Two words: sticky prices. Consider the four possibilities:

1. Weak yuan + US borrows


2. Strong yuan + US borrows


3. Weak yuan + US does not borrow


4. Strong yuan + US does not borrow

Which of these possibilities is optimal for the US? Tyler Cowen would probably choose #3, but he’s wrong. Not being a Keynesian, however, he won't appreciate why the correct answer is #4 (although Greg Mankiw should, so maybe he can tell me why I’m wrong).

Why not #3? Because if we choose what’s behind door #3, we get a huge and prolonged recession. A fiscal tightening, in the presence of a still-strong currency, will knock out the economy. (We kind of already tried that one back in 2000-2001. In that case the fiscal tightening came from the business sector, which continues to run a large surplus unto this very day. We have since had a recovery, a slow and painful one, brought about mostly by households and government, which are borrowing heavily, partly from China.) As long as China keeps our trade sector weak by keeping its currency weak, our optimal strategy is to borrow.

Furthermore, as long as the US is willing to borrow, it is in China’s interest (given the conservative preferences of its leaders) to keep its currency weak. If the US suddenly stopped borrowing, it would lower US interest rates and make dollars less attractive relative to yuan, forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise. As it is, the path of least resistance for China is to maintain the peg.

So there are two Nash equilibria, and we are stuck at the bad one. As long as the US borrows, it is optimal for China to peg. As long as China pegs, it is optimal for the US to borrow. Ultimately, both countries would be better off if the US stopped borrowing and China stopped pegging, but, as we say in Boston, you can’t get there from here.

I’m not sure how you get out of this bad equilibrium, but one possible way is by trying to change the preferences of China’s leaders, so that it will no longer be optimal for them to peg. I’m not sure how one goes about that, and Tyler Cowen may be right that political pressure is the wrong way, in which case I’ll concede the war but not the battle.

Q2 Labor Costs, Revised

The big increase in US hourly compensation in the second quarter didn’t make sense when it was first reported. Now that it has been revised upward, it makes even less sense. The best explanation I’ve heard comes from Dean Baker, who suggests, based on the NIPA statistical discrepancy, that some capital gains (obtained, for example, via exercise of employee stock options) might be misclassified as compensation. (Conceptually, in the case of stock options, the compensation took place when the options were granted, not when they were exercised. Anything that happened to the value in the intervening time was a capital change rather than income, but the value of the options doesn’t show up on the income side of the national accounts until they are exercised.)

Why Jane Galt is Still Wrong

I'm willing to bet a fairly hefty sum of money that almost none of the lefty bloggers who linked to it originally will link to my attempts to rectify their misunderstanding.

So writes Jane Galt. I don’t think I’m one of those she had in mind, since I didn’t deal directly with Ms. Galt’s arguments in my earlier posts (and I wouldn’t willingly accept the term “lefty,” though it’s possible that the shoe fits, or that it appears to fit). Nonetheless, I can’t resist the challenge.

Her words again:

…my metaphor was aimed at a specific kind of redistribution: that which is less interested in making the poor better off, than in making the rich worse off, so that they don't make the rest of us look bad. Or as Brad Delong said:

Surely public policy should weigh the spite-generated utility the rich gain from their conspicuous consumption as worth less than nothing?

And in that case, the wealth hierarchy is precisely equivalent to the beauty hierarchy, morally speaking: it is a zero sum game in which a lucky few feel better only when the others feel worse. So to my mind, anything that applies to the enjoyment of wealth by the lucky few applies equally well to the enjoyment of endowments like beauty, athleticism, and intelligence. I am unable to construct a moral argument for cutting down the tall poppies of the income distribution that doesn't apply equally well to conspicuous flaunting of one's pulchritude, physical prowess, or brains.

But how is it that she misses the critical point? To wit: the creation of conspicuous wealth, by its very nature, uses up resources that could be used for other purposes. Indeed, wealth might be defined as the ability to command resources, and therefore, the more resources that are used to produce conspicuous wealth, the more effective it is. By contrast, the process of flaunting one’s pulchritude, etc., while it may use up some resources, is not inherently resource-intensive. And certainly, such endowments, to the extent that they are truly endowments, don’t require resources to create.

The beauty hierarchy is, as Ms. Galt states, a zero-sum game (roughly), but – because of the resources used up – the wealth hierarchy could very well be a negative-sum game. Using up resources is fine as long as the full social benefit of the product exceeds the cost of the resources. But with conspicuous consumption that is not necessarily the case. Because there are negative externalities – namely the unhappiness (mistakenly labeled as envy) generated among inferiors – associated with that consumption, there is no mechanism to insure that the social benefit from the resources used is at least as great as the cost.

Of course there are counterarguments. For example, as Ms. Galt points out, there are also positive externalities associated with the pursuit of wealth. But those positive externalities have had their day in court. It is not at all fair to brush aside the negative externalities that may be associated with the pursuit of wealth (even if they are more difficult to measure).

Enough with the Envy and Spite Rhetoric

(See my last post, and its many links, for background.)

The terms “envy” and “spite,” it now occurs to me, not only frame the debate in an unpleasant light: they are also fundamentally inaccurate characterizations of the issue involved. Envy and spite are emotions directed at people: “I am envious of Peter”; “I am spiteful toward Paul”. These emotions imply hostility, which in fact has nothing to do with the argument that people derive utility from relative wealth. Thus Tyler Cowen Alex Tabarrok can complain that he doesn’t like being envied, but here he is talking about the actual emotion of envy (with all the attendant hostility), not about the property of certain utility functions that has been labeled as “envy.”

To say that I get utility from my relative wealth is not to say that I have any particular feeling about those against whom I compare myself. The word “envy” (and similarly the word “spite”) exaggerates the degree of other-regard that is present. The “others” in this case are not concrete people about whom I have feelings, but abstract reference points against which I compare myself. It’s not that the poor are envious of the rich; it’s that the poor feel bad about themselves when they compare themselves to the rich (or more likely to a social average in which the rich are only one element). Similarly, it’s not that the rich are spiteful toward the poor, it’s that they feel good about themselves when they compare themselves to the poor (or to the social average).

I doubt that Tyler Cowen Alex Tabarrok really gets significant disutility from being part of such an abstract reference point, but if he does, he seriously needs to chill. And his comparison of envy to homophobia is also “fruit of the poison tree,” since it derives from the original misuse of the word “envy.” The hatred that homophobes feel toward homosexuals is entirely other-regarding. Very much in contrast to relative wealth feelings, it has nothing (except at a deep psychological level) to do with what the homophobe feels about himself. Homosexuals have a legitimate complaint about being the objects of actual hate, rather than imagined envy.

In fact, when Brad DeLong brought the word “spite” into this discussion, he was conceding a point that he never should have conceded. The phrase “politics of envy” is used, by those who oppose redistribution, to frame the debate in emotional terms. The phrase may perhaps be a reasonably accurate characterization of the politics. To get people excited about redistribution – to get them to vote on that basis – you may have to make them emotional, literally “envious.” Rational arguments about their underlying preferences probably won’t do the trick. But Greg Mankiw let the term “envy” slip from the political argument into the economic one, where it becomes quite misleading. That, in my opinion, was a mistake that needs to be corrected before the discussion can proceed.

UPDATE: Oops, I referenced the wrong Marginal Revolution blogger (for this post).

Inequality, Spite, and the Game of Love

The debate du jour in the economic blogosphere seems to be about relative wealth – whether it affects welfare and whether public policy should take this possible effect into account. We have the usual dramatis personae, with Brad DeLong and Greg Mankiw in the leading roles, Jane Galt as the female lead, a cameo appearance by Chris Dillow, and Mark Thoma in the role of messenger (and let’s not forget Tyler Cowen…and now Gabriel Mihalache...and...and...and...never mind, I'm going to have to post this before I read every single blog). Most of the discussion concerns “envy” and “spite” – the supposed emotions of the poor and rich, respectively, which mediate the welfare effect of relative wealth.

I have a couple of points to bring up. First, from a utilitarian point of view, it doesn’t help Brad’s case that he points particularly to the spiteful rich rather than the envious poor. If the rich get pleasure from knowing they are better off than the poor, that, by itself, is a good reason to keep the income distribution unequal. Why not give the rich that extra pleasure of being relatively, rather than just absolutely, rich? The only utilitarian reason is that it (ostensibly) harms the poor, which is to say, in the terms of the discussion, that the poor are envious. Yes, I do understand that Brad is countering Greg’s comment about “making envy a basis for public policy,” but it seems to me that Greg's whole line of thought brings us into the realm of emotional, rather than rational, policy analysis. Greg casts redistribution in an unpleasant light by using the word “envy,” and instead of trying to cast it in a pleasanter light (“people like being equal”), Brad reflects back the bad light by using the word “spite.” In any case, it’s all mood music.

But I wonder why everyone (except Chris Dillow) thinks that the effect of relative wealth is merely subjective. As Chris points out, there are objective ways in which consumption by the rich may hurt the not-so-rich. I wonder why nobody has brought up what seems to me to be the obvious example: sexual competition. (For example, suppose you like tall redheads and you’re into spanking….OK, never mind.) I think particularly of competition among men, although arguments can also be made about competition among women. (My example also assumes, without loss of generality, that the men are heterosexual. And, oh, yes, back in the 80s I used to believe that stuff about men and women being roughly equal, so it didn’t matter who was chasing whom…but the 80s ended back in 1989, if I recall.)

In the area of beauty, evolution somehow seems to have failed the human male (well, most human males, anyhow: men are no plums, but they do contain the occasional Pitt). So men tend to compete for the attention of women not (like peacocks) on the basis of their natural endowment but on the basis of other things, which are often expensive. If I own a BMW and you buy a Jaguar, it hurts me objectively, because all the chicks that used to ride in my BMW will want to ride in your Jaguar instead. (In reality, it’s probably just as well that I drive a Saturn; my wife wouldn’t be too happy if I used the car to go cruising for chicks.) There’s no envy or spite involved here: just men who are competing rationally and women who like men with fancy cars. Although the competition has some benefit for the women involved, it’s easy to see that there’s also a deadweight loss. It’s a multi-player prisoner’s dilemma, and there is no mechanism to produce a cooperative solution.

UPDATE: Steve Waldman brings up another, much more important (but less sexy!) area in which objective competition causes relative wealth to have an impact: politics.

UPDATE2: I missed Alex Tabarrok’s important post, which might sort of provide a justification for Brad’s focus on spite. Also this other one by Gabriel Mihalache.

Employment: No News is Good News

Now that Calculated Risk has pointed me out as one who follows such things, I feel obliged to comment on the labor indicators that have come out over the past 2 days. Overall, they were a bit stronger than I expected, but a bit weaker than I think the market expected.

Yesterday, we had both the July Help Wanted Index from the August Monster Employment Index. The picture is mixed. The Monster index bounced back from the distressing drop in July, and my first impulse was to put up a post under the title “Friendly Monster” to contrast with my earlier “Scary Monster” post. On closer analysis, though, the bounceback was not as impressive as it first appeared. The index rose from 165 to 173. In percentage terms, that increase is a little bit smaller than last year’s July-to-August bounce, but a little bit larger than the one in 2004. Since last year was a year of substantial job growth, I would say this year’s bounce still certainly goes in the “good news” column, but it is not large enough to make up for the unexpectedly large drop in July.

The Help Wanted Index dropped to 32 from an upwardly revised 34 in June. This leaves it a point lower than the original June report, which was already coming on the heels of a dramatic drop from February to May. The index is getting closer to its record low of 24 set in April 1958, and remember that the labor force has more than doubled in size since then. Relative to the level of payroll employment, the July figure is actually the fourth successive record low. If we combine the July Help Wanted Index with the August Monster index (using a procedure described briefly here) and normalize by payroll employment, the result is just 1.6% above the record low set in May 2003, and 15.5% below the recent peak in February.

Then there is the Employment Situation report that came out this morning. It adds up essentially to no news, which is news to me, because I expected it to be weaker than expected. Payroll growth at 128,000 is right in the middle of the range of values that are typically given as being sufficient to absorb the expected population growth. If you think the long-term trend in labor force participation is accelerating downward, then 100,000 might be enough, but if you attribute the decline since 2000 to a weak job market, then something like 155,000 are necessary. I tend to lean toward the high end of that debate, meaning I think that the August growth was a bit weak, but there is room for disagreement. Interesting that construction employment was up. Given what builder confidence indicators are saying, I expect that will change in coming months. Other than that I haven’t yet found anything interesting in this report.